Banking Without Regulation

Friday, October 1, 1993

How well would the banking system work if there were no government regulation? One way to begin answering this question is to examine the historical record. In the 19th century many countries had relatively unregulated banking systems with few or none of the restrictions that face American banks today: legal barriers to new entry, deposit insurance, geographic and activity restrictions, reserve requirements, and protection of favored banks from failure. Because these systems were so different from today’s, they throw valuable light on the possible consequences of completely deregulating banking in the future.

A useful source of historical information is the recently published volume entitled The Experience of Free Banking, edited by Kevin Dowd (London: Routledge, 1992). The book’s contributors (of which I am one) investigate relatively unregulated banking systems in nine different countries during the 19th century: Australia, Canada, Colombia, China, France, Ireland, Scotland, Switzerland, and the United States. An overview chapter by Kurt Schuler shows that there were another fifty episodes that might also be investigated in detail. Fresh historical evidence, of the sort provided in this book, usefully complements the several other studies of free-market money and banking that have been published in recent years.[1]

What can we learn from historical episodes of relatively unregulated banking? I will try to summarize three main lessons concisely, without all the details, footnotes, and minor qualifications that might be mentioned. I hope my fellow academics will forgive me for breaching our professional etiquette in this way.

Unregulated Banking Does Not Cause Inflation of the Money Supply or of Prices

Over the long run of generations, price inflation was virtually zero.

Because reserve requirements constrain banks today, economists have sometimes feared that banks without reserve requirements will face no constraint against oversupplying checking deposits or banknotes. But the fear is historically groundless. A competitive market compels unregulated banks to fix the value of their deposit and note liabilities in terms of the economy’s basic money, by offering redeemability at par (full face value) in basic money. In the past, the basic money was gold or silver coins. The “dollar” was originally a silver coin. To avoid embarrassment, in the absence of government protection, a bank could not issue too many liabilities in relation to its reserves of metallic money.

Under redeemability, the value of money falls (price inflation occurs) only when the supply of the economy’s basic money grows faster than the real demand for basic money. Under the gold and silver standards of the 19th century, inflation of prices in any single year was minimal by modern standards. Over the long run of generations, price inflation was virtually zero.

Unregulated Competition among Banks Does Not Destabilize the Banking System

Instability is often the fear of those who think that “free banking” laws in some parts of the antebellum United States led to irresponsible or “wildcat” banking. It turns out that “wildcat” banking is largely a myth. Although stories about crooked banking practices are entertaining—and for that reason have been repeated endlessly by textbooks—modern economic historians have found that there were in fact very few banks that fit any reasonable definition of "wildcat bank." For example, of 141 banks formed under the “free banking” law in Illinois between 1851 and 1861, only one meets the criteria of lasting less than a year, being set up specifically to profit from note issue, and operating from a remote location.[2]

Depositors were more careful in choosing banks, and banks correspondingly had to be more careful in choosing their asset portfolios than banks are today.

The so-called “free banking” systems in a number of antebellum American states were actually among the most regulated of all the 19th-century systems of competitive note-issue. Instability was experienced in a few states, not due to wildcat banking, but due to state regulations that inadvertently promoted instability. “Free banking” regulations in some states made it easier to commit fraud; in other states, the regulations discouraged or prevented banks from properly diversifying their assets. Banking was more stable in the less-regulated systems of Canada, Scotland, and New England.

How was stability possible in banking systems with neither deposit guarantees (nothing like FDIC insurance) nor a government lender of last resort (nothing like the Federal Reserve)? Depositors were more careful in choosing banks, and banks correspondingly, in order to attract cautious customers, had to be more careful in choosing their asset portfolios than banks are today in the presence of deposit guarantees and a lender of last resort. Banks did sometimes fail. But bank failures were almost never contagious, or prone to spread to sound banks, for several reasons.

Each bank tried to maintain an identity distinct from its rivals and was able to do so when it was not compelled by any regulation to hold a similar asset portfolio. Depositors then had no reason to infer from troubles at one bank that the next bank was in trouble. Banks were generally well capitalized, so that fear of insolvency was remote. In some cases, banks had extra capital “off the balance sheet” in the sense that shareholders contractually bound themselves to dig into their own personal assets to repay depositors and noteholders in the event that the bank’s assets were insufficient. Banks diversified their assets and liabilities well, being free of line-of-business and activity restrictions.

The Federal Reserve System did not introduce, but simply nationalized, bank regulation and the lender-of-last-resort role.

Banks were careful to avoid excessive exposure to other banks, which means that they minimized the risk of being stuck with uncollectible claims on other banks. Some degree of exposure is unavoidable in any system in which a bank accepts deposits from its customers in the form of checks written on, or notes issued by, certain other banks. A bank has exposure until it clears and settles those claims through the clearinghouse.

Private clearinghouses, particularly in the late 19th-century United States, lowered the risks of interbank exposure by making banks meet strict solvency and liquidity standards for clearinghouse membership. Clearinghouses were a vehicle by which reputable banks as a group voluntary regulated themselves. Clearinghouse associations pioneered techniques for monitoring and enforcing solvency and liquidity, such as balance sheet reports and bank examinations. Clearinghouse associations also did some “last resort” lending to solvent member banks that were experiencing temporary liquidity problems. The Federal Reserve System did not introduce, but simply nationalized, bank regulation and the lender-of-last-resort role.

Banking Is Not a Natural Monopoly

Historical experience shows that there are some tendencies for larger banks to be more efficient, but not beyond a certain size. Nationally branched banks do tend to out-compete smaller banks in many areas of the banking business, but not in all areas. Banks must be large enough to diversify their assets and liabilities adequately, but this does not require being large relative to the entire banking market.

Recent developments in the financial technologies of loan syndication and securitization may have reduced the size at which a bank becomes large enough in this respect. In the absence of government regulations that currently favor the largest banks, particularly the pursuit of the “too big to fail” doctrine by the Federal Reserve and the Federal Deposit Insurance Corporation, a stable and deregulated financial structure would result that would likely include both large and small banks.

This statistic, from a study by Andrew J. Economopoulos, is cited by Kevin Dowd, “U. S. Banking in the ‘Free Banking’ Period,” in Dowd, ed., The Experience of Free Banking (London: Routledge, 1992), p. 218. Pioneering modern work on the U. S. experience with “free banking” laws, which is the source for the information in the next paragraph of the text, has been done by Hugh Rockoff and by Arthur J. Rolnick and Warren E. Weber.